How High Can Oil Prices Go After OPEC Deal?

As we expected, OPEC was able to successfully stick the landing and come up with a comprehensive agreement to cap output at 32.5 mb/d – in line with September’s Algiers Accord.

The individual member countries agreed to cut production by roughly 4.5% – for a total combined cut of 1.2 mb/d – with special exemptions for Libya and Nigeria and something of a work around arrangement for Iran. Instead of slashing output from current levels, Iran’s cut will be taken from their post 1979 production high of 3.975 mb/d (July 2005). While this basically amounts to a near term freeze rather than an actual cut, this is a face saving compromise measure, needed to eliminate what had emerged as one of the biggest stumbling blocks in the last 48 hours. In a move that raised fears of a Doha redux, Saudi Arabia sharply stepped up calls for Iran to join any OPEC action and threatened to walk away from a deal in the event of non-participation.

Iran, for its part, repeatedly doubled down on its call to be able to return to presanctions production levels. The other major speed bump was Iraq, which had initially sought an outright exemption and then later insisted on using self-reported numbers as the basis of any coordinated output action – a number that is around 250 kb/d higher than secondary source estimates (and likely is derived from double counting Kurdish fields). In the end, Iraq accepted a 210 kb/d cut from the secondary source number of 4.561 mb/d). Hence, the Iraqi climb down was even steeper than the Iranian one and seemingly vindicates the Saudi strategy of playing hardball with its biggest cartel (and regional) rivals. Indonesia, a net importer, had publicly questioned the utility of an output cap in recent days and opted to suspend its membership rather than join a cut.

The other major development was the announcement of a 600 kb/d non-OPEC cut. While the full participation details remain to be worked out, Russia reportedly agreed to cut 300 kb/d of production instead of merely freezing production at current levels. OPEC officials were somewhat evasive when asked how the cartel would respond to a breach of the agreement by non-OPEC members, instead repeatedly expressing confidence that the producers would fully comply with their commitments, which are set to be announced on December 9 in Doha.

As with the Algiers Accord, we believe that today’s announcement reflects the tough economic circumstances faced by the sovereign producers and the desire for a measure of relief to shore up domestic support. We note that even a recovery to the mid $50s still leaves our fragile five at heightened risk for instability and supply disruptions, most notably Venezuela and Nigeria. For Saudi Arabia, the 180-degree shift in favor of a detailed OPEC cut, with robust non-OPEC cooperation to enhance credibility, likely reflects the leadership’s desire to see the key Vision 2030 priorities realized (principally the planned IPO of Saudi Aramco). Today’s decision will likely be very well received by the Saudi public, which is struggling in the face of sharp spending cuts and austerity measures. Oil in the $50s will also help the Kingdom avoid costly credit ratings downgrades as it ramps up borrowing. As long as Saudi Arabia remains firmly committed to the deal, which is slated to last for six months (or longer with a six-month extension option) we believe that the arrangement will hold.

Moreover, the opportunities for cheating are somewhat reduced by the fact that the most likely unfaithful suspects are either already exempted or already seeing their production trending downwards due to internal problems.

Slow and Steady Wins the Sustainable Recovery

As we mentioned in our pre-meeting report, varying levels of execution have varying implications for prices, market balances and sentiment. While the announced 1.2 mb/d output adjustment made in order to reach the group ceiling of 32.5 mb/d is ‘headline’ constructive, the introduction of individual country production levels and more importantly, the establishment of a Ministerial Monitoring Committee to act as an enforcement mechanism, inserts an obligatory layer of legitimacy that has eluded the cartel in recent years. Additionally, the inclusion of two non-OPEC countries to the monitoring committee adds an unforeseen level of validity that should help to quell critics on participation from both the cartel and non-OPEC participants. In other words, today’s announcement is the strongest statement, with key quantifiable measures of accountability, seen from the group in recent years. Critics of the deal may suggest that the six-month time frame of the deal may perhaps not be lengthy enough (note that the deal is extendable at the next meeting), but we think less emphasis should be placed on the tenor of the deal given that official OPEC meetings typically take place twice a year and group policy is constantly under evaluation based on market dynamics.

We have always viewed oil’s global rebalancing act as a two-tiered process. The first step consists of ridding the market of the daily supply imbalance, which we believe has largely occurred. Today’s announcement helps to kick start the second step, which involves running down the significant global storage surplus to historically normal levels, a feat that will likely remain elusive until late 2017, at best, in our view. As we have previously suggested, the price path forward is extremely critical to the sustainability of the rally. While many market participants will undoubtedly view today’s announcement as an attempt by cartel members to shore up fiscal balances (among other things), there is much at play. In fact, it is important to remember that OPEC’s experiment continues, as the Saudi-led cartel continues to gather data points on non-OPEC production growth at varying price points, particularly from US shale plays. A slow and steady move higher in prices ultimately wins the sustainable recovery, in our view, and we continue to see prices grinding upwards over the coming quarters rather than gapping significantly higher. Global oil balances remain fragile, caught in a push-pull situation where the global rebalancing act repeatedly proves it is indeed a lengthy process, while the elasticity of US shale has proven itself a quicker process. In other words, a sharp move higher in prices could inadvertently resurrect price-sensitive non-OPEC production. As such, we maintain our view that WTI will average $56.40/bbl next year with H1 2017 averaging in the low $50s before inching into the low $60/bbl range by late next year.

This copy is for your personal, non-commercial use only. Distribution and use of this material are governed by our Subscriber Agreement and by copyright law. For non-personal use or to order multiple copies, please contact Dow Jones Reprints at 1-800-843-0008 or visit www.djreprints.com.